I don't think the plan will work either (for many of the reasons you've given), but I'm not as sure about this one:
The market value of a $200k mortgage for a $100k house is NOT $80k, or even $100k. Even if the mortgage is currently in default, it still represents ownership of a house worth $100k; by definition that makes it worth $100k, no $80k...
The market value of the mortgage is whatever it would actually sell for on the open market. I don't see a strong reason to believe it would always be equal to the price the underlying asset would sell for. Sometimes owning the mortgage is more valuable than the underlying property, because you've locked in a good interest rate and cash stream. Other times it's less valuable, because you have potential hassles over eviction, damage, etc., or because you've locked in a bad interest rate (the latter being the same reason bonds can be worth less than their face value).
In a situation like Richmond's housing market, with high default rates, it wouldn't be too surprising that an unencumbered property could sell for more than a mortgage on the same property would sell for. If I were buying, I would certainly demand a discount on the property to compensate for the risks of taking over the mortgage and a house with a resident in it, versus the situation of buying the property completely free and clear. That's not even specific to mortgages; any asset with a contract attached to it will be valued by taking into account the contract.
> The market value of the mortgage is whatever it would actually sell for on the open market.
Yes. But as a practical matter, the market value of an underwater but performing loan is going to be significantly higher than the underlying asset, and most of the loans in the pool Richmond is looking at are performing.
A defaulted loan might be worth nothing more than the underlying asset less foreclosure costs (which can, as you note, be high); in some cases that might work out to be around 80% of the house value (which is what Richmond plans to offer), so in a small minority of cases Richmond's plan may pass constitutional muster. Unfortunately, their plan then relies on turning around and having the same home buyer get a new mortgage. I'll give you three guesses as to how easily a guy who just defaulted on his last mortgage will get a new one on the same house...
In short, yes, valuing mortgages is complicated. But they are liquid, traded investments, and the market price is simply higher than Richmond is offering on average. And the minority where it isn't won't work on its own.
It's an interesting hypothetical, but presumably there is data about how much mortgages are worth along all these axes, since they are traded fairly heavily. We don't need to guess about it.
The challenge here is that the mortgage has a different valuing scheme than the property. The mortgage is valued against the rate of return and the risk of default. The property is valued against comparable properties.
The whole problem here is that you might have a $200K mortgage which is written to a very credit worthy borrower who is paying on time, against a house with a market value of $100K (probably not in the Bay Area but this is just an example).
So the fair market value of a $200K mortgage, that matures in 2033 might be $100k (this is essentially a zero coupon bond at this point and we're assuming a 3.5% rate of return) could be "destroyed" (which is to say seized by eminent domain) and replaced with a $100K mortgage that matures in 2043 (assuming a 30 yr mortgage). That is worth something like $35,000 (again assuming an annual rate of 3.5%) which quite a bit less than $100K,
So looking at it as an investor you've had $100K worth of "principal" stolen from your retirement account by the City of Richmond, and sold to someone else for basically 1/3 the price, because the underlying basis for this particular investment vehicle was someones home, which is now underwater value wise.
The saddest part of the mortgage mess is that it is so freakishly complicated to figure out what or who owns a mortgage in the world of derivatives. If Richmond is successful (and I hope they are) the next story will be people who have this sudden drop in their 401k investment value with a note "Funds taken by City of Richmond" ) and those folks are going to go "WTF?" and the next round of scare stories will be "Richmond just yanked nearly a billion dollars out of people 401k funds and gave them to a Hedge fund, could you be next?" And nobody will be calling for the real reform which is some level of regulation on what you can and cannot do with a home mortgage security.
The market value of a $200k mortgage for a $100k house is NOT $80k, or even $100k. Even if the mortgage is currently in default, it still represents ownership of a house worth $100k; by definition that makes it worth $100k, no $80k...
The market value of the mortgage is whatever it would actually sell for on the open market. I don't see a strong reason to believe it would always be equal to the price the underlying asset would sell for. Sometimes owning the mortgage is more valuable than the underlying property, because you've locked in a good interest rate and cash stream. Other times it's less valuable, because you have potential hassles over eviction, damage, etc., or because you've locked in a bad interest rate (the latter being the same reason bonds can be worth less than their face value).
In a situation like Richmond's housing market, with high default rates, it wouldn't be too surprising that an unencumbered property could sell for more than a mortgage on the same property would sell for. If I were buying, I would certainly demand a discount on the property to compensate for the risks of taking over the mortgage and a house with a resident in it, versus the situation of buying the property completely free and clear. That's not even specific to mortgages; any asset with a contract attached to it will be valued by taking into account the contract.